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Higher taxes may not hammer dividend stocks

So did higher taxes prompt investors to ditch dividend stocks? Not at all. Between 1990 and 1993, dividend-paying stocks returned an average of 12 percent a year. The S&P 500 returned an average of 10.7 percent.

Armed with these studies, some investors are arguing that dividend-paying stocks, especially those backed by large, cash-rich companies, will remain a relatively safe bet if Congress and Obama can't make a deal.

Without an agreement, stocks of all kinds are likely to fall. Since voters returned Obama and a divided Congress to power Nov. 6, the Dow Jones industrial average has fallen 700 points, more than 5 percent.

But dividend-paying companies, typically cash-rich and dependably able to churn out profits, could hold up better than others, even as taxes on them climb.

A group at Fidelity Investments took another angle and looked at dividend-paying stocks in the year before and after Congress approved the Bush tax cuts in May 2003.

If lower tax rates made stocks more appealing, they figured companies that raised their dividends would see their stock prices surge.

It turned out that the most generous companies, the top fifth in terms of dividend yield, fared the worst over the two years, while stingy stocks did well. Companies weren't being rewarded for paying dividends, and they scaled back.

"After the Bush tax cuts you'd think, 'Hey, here comes a surge in dividends,'" says Morrow, the Fidelity fund manager. "What did we see? The exact opposite. Dividends are at an all-time low."

Companies in the S&P 500 paid 27 percent of earnings to investors in dividends last year, according to research from Goldman Sachs. Over the past 50 years, the payout ratio has rarely dropped below 40 percent.

If history is any guide, companies may decide to protect investors from higher taxes by rewarding them with higher dividends, according to a Goldman Sachs report.

In 1960, when Dwight D. Eisenhower was president, rich Americans paid a tax on dividends as high as 91 percent because that was the top marginal income tax rate. And companies were much more generous. They paid 64 percent of earnings in dividends.

Even assuming dividend taxes rise, dividend-paying stocks will still be an attractive alternative to some other investments.

For example, 10-year Treasurys yield about 1.6 percent. That's substantially below the average 2.6 percent yield of dividend-paying companies in the S&P 500. Both would be taxed as ordinary income.

Koesterich, from BlackRock, says companies have plenty of room to raise dividends to compensate investors for the bigger cut they're handing to Uncle Sam.

"They certainly have the ability," Koesterich says. "And they know a substantial portion of people are buying their stock because of the yield."